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Wednesday, March 19, 2014

Fed Watch: That Train Left the Station

Tim Duy:

That Train Left the Station, by Tim Duy: I was re-reading some of the recent overshooting debate and it occurred to me that it is comical that we are even having this discussion. The Fed is not going to deliberately overshoot inflation, period. That train left the station long ago. So long ago that you can't even here the rumble on the tracks.
The train left the station on January 25, 2012, with this statement by the Federal Reserve:
The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.
On that day, the Federal Reserve locked in the definition of price stability. They locked it in specifically to prevent even the appearance they might deliberately overshoot as a result of extraordinary monetary policy. They locked it in as a commitment device to tie the hands of future policymakers as they would need to justify changing the definition of price stability, presumably a very high bar for any central banker to cross.
On that day, the Federal Reserve took higher inflation expectations off the table. They pulled it from the toolkit. They made clear there is one and only one inflation target for all time. The only tolerable deviations from that target are essentially forecast errors. That's it.
Moreover, I would argue that their behavior has been entirely consistent with maintaining that expectation. Inflation expectations - as measured by TIPS - have been more volatile than prior to the recession, but have cylced around pre-recession levels, or, arguably, a little below:


There is no reason to believe that the Fed has acted to try to sustain inflation expectations beyond those in place prior to the recession. Perhaps thay came close in late-2012, as measured by the five year, five year forward breakevens:


But that was soon met by official pushback. Via Bloomberg:
“Distant inflation expectations from the TIPS market seem to suggest that investors do not completely trust the Fed to deliver on its 2 percent inflation target,” Bullard said today in a speech in Memphis, Tennessee, referring to Treasury Inflation-Protected Securities...
...The five-year, five-year forward break-even rate, which projects the pace of price increases starting in 2017, rose to 2.88 percent on Sept. 14, the day after the FOMC announced a third round of quantitative easing. That was up half a percentage point from July 26. It dropped to 2.77 percent on Oct. 2.
Soon thereafter began the tapering chatter that ultimately culminated in then-Chairman Ben Bernanke's press conference in which he introduced the 7% trigger for asset purchases. The result was a sharp snap-back in real yields:


If the Fed has already proved they can't stomach inflation expectations hovering just below 3% (remember that this is on a CPI basis by which TIPS are calculated, not on a PCE basis that is the Fed's target) for even a few months, they really can't wrap their minds around inflation actually reaching 3% as suggested by Karl Smith:
The Evans Rule was nice, but addressing the overshoot directly would be better. For example, a statement like: “In the committee’s view the appropriate path for the federal funds rate would, in the medium term, allow inflation to rise above 2 per cent, but not above 3 per cent, for a period no less than three months but no greater than one year. Within those parameters the committee will continue to adjust the target for the federal funds rate so as to achieve maximum employment and keep long term inflation expectation well anchored.”
And note that I am being generous by trusting that the Fed's inflation target is actually 2%. David Beckworth suggests it is actually the range of 1% to 2%.
Ultimately, I think Robin Harding correctly identifies the mood at the Fed:
Even Janet Yellen, in her “optimal control” speeches in 2011 and 2012, never argued that the Fed should promise extra inflation in the future. There has never been much support for it on the FOMC and the Fed’s statement of long-run goals would have to be modified to allow for it. At this stage in the game, when the Fed is slowing down its stimulus via asset purchases, it makes little sense to add more stimulus in another way.
What remains the case is that Fed doves think there is slack in the labour market and are willing to risk some above target inflation – while targeting 2 per cent – in order to bring joblessness down more rapidly. I think the centre of the committee under Janet Yellen agrees (and their fairly aggressive forward rate path reflects that). In an ideal world, though, the Fed would gracefully stabilize inflation at 2 per cent with no overshoot or undershoot, creating a soft landing as the economy regains full employment.
The Evans rule was never about higher inflation expectations. It only clarified the acceptable range of forecast errors around the 2% target for a given unemployment rate. And note that it is clear that a forecast error in the other direction is also acceptable with below target outcomes in the labor market. That acceptability is evident in the eagerness to end asset purchases and telegraph the first rate hike. Does anyone believe that the Fed would find a 2.5% inflation rate acceptable if unemployment is at 6%? Or would it be cause of worry and hand-wringing among policymakers? The latter, I think. Yes, they are willing to risk some above target inflation, but should it actually emerge, they would act quickly to snuff it out.
Bottom Line: Expect the Fed to manage policy to contain disinflation and deflationary expectations. But overshooting in the sense of raising inflation expectations to lower the real interest rate further? It very much seems like they made clear long ago that wasn't an option.

    Posted by on Wednesday, March 19, 2014 at 12:15 AM in Economics, Fed Watch, Monetary Policy | Permalink  Comments (56)


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